Risk, Return and Interest Rates Assoc. Prof. Hülya Hazar

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BUS 362 Financial Institutions and
Markets
Week 4: Risk, Return and Interest Rates
Assoc. Prof. Hülya Hazar
Faculty of Economics and Administrative Sciences, Department of
Business Administration
[email protected]
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Financial Institutions and Markets
1. Risk Structure of Interest Rates
2. Term Structure of Interest Rates
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Financial Institutions and Markets
Risk Structure of Interest Rates
• Risk factors
• Default Risk
• Liquidity
• Income Tax Considerations
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Financial Institutions and Markets
Default risk: The debtor is unable or unwilling to make interest
payments when promised.
Default-free bonds: Bonds with no default risk are called
default-free bonds.
Risk premium:
• The spread between the interest rates on bonds with default
risk and default-free bonds, called the risk premium.
• It indicates how much additional interest people must earn in
order to be willing to hold that risky bond.
• Default risk is an important component of the size of the risk
premium.
• Because of this, bond investors would like to know as much
as possible about the default probability of a bond.
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Financial Institutions and Markets
Bond Ratings by Moody’s and Standard and Poor’s
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Financial Institutions and Markets
Liquidity
• A liquid asset is one that can be quickly and cheaply
converted into cash if the need arises.
• The more liquid an asset is, the more desirable it is.
• The differences between interest rates reflect its liquidity too.
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Financial Institutions and Markets
Income Tax Considerations
• Interest payments on government bonds are exempt from
income taxes, a factor that increases in their expected
return.
• Interest payments from corporate bonds are fully taxable.
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Financial Institutions and Markets
Term Structure of Interest Rates
• Maturity : The number of years (term) until the expiration date.
• Different maturities have different interest rates
• Yield curve: rates at different maturities
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Financial Institutions and Markets
Three Theories of Term Structure:
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Expectations Theory
Market Segmentation Theory
Liquidity Premium Theory
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Financial Institutions and Markets
Expectations Theory:
• The long-term interest rate is the average of the current and
expected future short-term rates.
• For example, the yield to maturity on a five-year bond is the
average of the current and expected future short-term rate
for the next five years.
• The expected wealth is the same at the start. The actual
wealth may differ, if rates change unexpectedly after a year.
• The theory also believes that because people make
decisions based on the available information at hand
combined with their past experiences, most of the time their
decisions will be correct.
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Financial Institutions and Markets
Market Segmentation Theory:
• Long and short-term interest rates are not related to each
other.
• Interest rates for short, intermediate, and long-term bonds
should be viewed separately like items in different markets
for debt securities.
• People typically prefer short holding periods and thus have
higher demand for short-term bonds, which have higher
prices and lower interest rates than long-term bonds.
• Market segmentation seeks to identify targeted groups of
consumers to tailor products and branding in a way that is
attractive to the group. Markets can be segmented in several
ways such as geographically, demographically, or
behaviorally.
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Financial Institutions and Markets
Liquidity Premium Theory:
• People do prefer liquid assets more often due to fewer risks
in short-term assets.
• It means lesser risks like default risk.
• Investors prefer short-term rather than long-term bonds. This
implies that investors must be paid positive liquidity premium
to hold long term bonds.
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Risk, Return and Interest Rates Assoc. Prof. Hülya Hazar

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